On December 6, 2011, the International Swaps and Derivatives Association, Inc. (“ISDA”) published sample tri-party provisions intended to assist market participants in the negotiation of provisions relating to the segregation of excess collateral, or “independent amounts.” The Dodd-Frank Act (the “Act”) imposes certain requirements for dealers to collect initial and variation margin from their counterparties. The sample provisions effectively provide market participants with suggested mechanics to implement Sections 724(c) (regarding “swaps”) and Section 763(d) (regarding “security-based swaps”) of Title VII of the Act, which generally require that dealers provide their end-user counterparties with the option of having independent amount collateral they deliver be segregated and held by a third-party custodian.
The genesis of the sample provisions was an examination by ISDA, the Securities Industry and Financial Markets Association and the Managed Funds Association of the risks associated with independent amounts, which came into greater market focus when counterparties were unable to access excess collateral held directly by Lehman Brothers after its collapse. A March 2010 white paper released by the three organizations discussed alternatives for holding independent amount collateral. The white paper discussed three alternative holding arrangements, each with its own risks and costs: (i) direct holding, where the pledgor delivers collateral directly to a secured party or its affiliate; (ii) third party custody, where an unaffiliated third party provides custodial services to one of the two parties; and (iii) tri-party custody, where a third party provides custody services under a three-way contract. In addition, the white paper recommended that standard collateral provisions be developed that could be incorporated by negotiating counterparties into the relevant holding arrangement documentation.[1]
The sample provisions recognize that, of the various collateralization alternatives, tri-party custody arrangements are generally the most time-consuming and expensive to negotiate. As a result, the sample provisions suggest provisions that negotiating parties may use to amend the relevant ISDA Credit Support Annex (the dominant security agreement in the marketplace for derivatives transactions) to require the segregation of independent amount collateral (i.e., to prohibit the reuse or rehypothecation of collateral) and to create a separate pool of independent amount collateral (instead of commingling it with variation margin). The sample provisions also include numerous attachments addressing matters such as the allocation of custodian risk and the mechanics of dispute rights, which the parties may consider negotiating into their bilateral arrangements. Finally, the sample provisions include alternative formulations for accessing independent amounts which the contracting parties may include in tri-party control agreements with the custodian.
As the regulatory environment develops, certain high-profile losses of counterparty collateral held as swap (or futures) security has resulted in a trend towards establishing more robust protections for collateral. For uncleared trades, the sample provisions will assist counterparties in considering various alternative collateral arrangements and simplifying their negotiations to effect those arrangements. Nevertheless, a party’s specific circumstances and approach towards risk tolerance, as well as the identity and strength of its counterparty, will dictate the approach and provisions that are most beneficial for that party in its collateral documentation.
[1] For additional information about this white paper, please click here.